Stock market is a wild card in fiscal cliff talks

WASHINGTON (AP) -- Congress and the White House can significantly soften the initial impact of the "fiscal cliff" even if they fail to reach a compromise by Dec. 31. One thing they cannot control, however, is the financial markets' reaction, which possibly could be a panicky sell-off that triggers economic reversals worldwide.

The stock market's unpredictability is perhaps the biggest wild card in the political showdown over the fiscal cliff.

President Barack Obama's re-election gives him a strong negotiating hand, as Republicans are increasingly acknowledging. And some Democrats are willing to let the Dec. 31 deadline pass, because a rash of broad-based tax hikes would pressure Republicans to give more ground in renewed deficit-reduction negotiations.

A chief fear for Obama's supporters, however, is that Wall Street would be so disgusted or dismayed that stocks would plummet before lawmakers could prove their newfound willingness to mitigate the fiscal cliff's harshest measures, including deep, across-the-board spending cuts that Defense Secretary Leon Panetta says could significantly damage the nation's military posture. Some Republicans believe that fear will temper the president's insistence on a hard bargain this month. Obama and GOP House Speaker John Boehner on Sunday held their first meeting between just the two of them since the election, and spokesmen for both emphasized afterward their lines of communication remain open.

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The so-called cliff's recipe of major tax hikes and spending cuts can actually be a gentle slope, because the policy changes would be phased in over time. Washington insiders say Congress and the White House would move quickly in January or February to undo many, but not all, of the tax hikes and spending cuts.

Financial markets, however, respond to emotion as well as to research, reason and promises. If New Year's headlines scream "Negotiations Collapse," an emotional sell-off could threaten the president's hopes for continued economic recovery in his second term, even if Republicans receive most of the blame for the impasse.

Some Republicans are surprised that the White House has not made clearer efforts to reassure Wall Street that if the Dec. 31 deadline is breached, the worrisome pile of tax increases and spending cuts would not hit all at once.

A few liberal commentators are making just that case.

"If we go past the so-called fiscal cliff deadlines and all the resulting budget cuts and tax increases come into force, the administration can minimize the damage," Washington Post columnist E.J. Dionne wrote last week. "Obama can publicly announce he is delaying any cuts, on the theory that Congress will eventually vitiate some of them. And he can make sure the bond markets know of his plans well in advance. ... Everyone (especially Wall Street) should calm down."

Some financial bloggers agree. "Although it would be bad to let the spending cuts and tax hikes fully go into effect, if this thing is addressed in early January, things will be okay," wrote Business Insider's Joe Weisenthal.

So far, the stock markets have stayed calm. The S&P 500 index is up 12 percent for the year.

That might be because investors agree that a temporary trip over the cliff wouldn't be too harmful. Chastened lawmakers, the thinking goes, would quickly minimize the economic damage with a deficit-reduction compromise that eluded them in December.

Or, it's possible that investors view the most pessimistic tones surrounding the fiscal cliff talks as posturing that will give way to a last-minute deal. If that is the thinking -- and if the Dec. 31 deadline instead is breached -- Obama's fear might come to pass: The expectation of a deal might produce a significant decline in stock prices if it doesn't occur.

As bad as that sounds, some liberals think it will be necessary to force many Republicans to drop their opposition to higher tax rates on the wealthy that Obama says are crucial to trimming the deficit.

Rep. Peter Welch, a Vermont Democrat who says temporarily going over the cliff wouldn't be so bad, noted what happened on Sept. 29, 2008. The House surprised investors by rejecting a proposed bailout of the crisis-stricken financial sector. Republicans strongly opposed the plan despite then-President George W. Bush's support. The Dow plunged 777 points, its largest one-day point drop ever.

Four days later the House, shaken by the market reaction, passed a slightly modified bailout bill.

Welch said a similar market meltdown next month, in the event of a fiscal cliff impasse, "is what will force members of Congress eventually to act."

Few lawmakers in either party are eager to predict how the stocks and bonds markets would react to a failure to reach a fiscal cliff accord by year's end.

"Let's not pretend the markets fully understand the politicians, or the politicians fully understand the markets," said Rep. George Miller, D-Calif., who has served in Congress for 37 years.